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​Brexit Highlights the Need to Be Ready for Anything

Most of the time, the economic environment doesn't change noticeably from month to month. But policy changes can be abrupt and generate a range of potential short- and long-term effects. We saw an example of this in the closing weeks of June, with the United Kingdom's decision to leave the European Union, a decision that could have implications for the U.S. economy and for the credit union system.

There were a number of economic, political and societal factors that contributed to the decision to leave the EU—many of which are outside our expertise. What happens next is not quite clear. However, what has been clear is the market reaction to Brexit, and it has been dramatic and swift.

In the days immediately following the June 23 vote, corporate equity markets took a steep dive. The S&P 500 Index fell 5.3 percent. In Europe, the Stoxx 600 index fell approximately 11 percent. The British pound and the EU euro both depreciated sharply relative to the U.S. dollar as analysts reassessed the potential for growth in the United Kingdom. Oil and other commodity prices moved lower, reflecting a greater likelihood of slower economic growth in the near term.

Government bond yields also dropped as investors looked for safer investments. The flight to quality pushed the 10-year Treasury yield down near record-low levels. This pushed the average rate for a 30-year fixed-rate mortgage, which is tied to the 10-year, down to 3.48 percent in the last week of June.

Markets did recover some of their losses by the middle of the following week. However, we can expect continued volatility in the near future, as analysts assess the potential for slower growth in the Euro zone and the U.K., and especially if other nations follow the U.K.'s lead and hold their own referendums to leave the EU or if there is any further political and economic fallout in the U.K.

Now, it's hard to predict how these developments will ultimately affect the U.S. economy, but analysts believe the effects could be meaningful.

First, the EU is an important trading partner for the U.S. In 2015, about 18 percent of U.S. goods exports went to EU member countries. That's about the same share exported to Canada, our largest single export market. The U.K. alone accounted for close to 4 percent of all U.S.-made goods shipped overseas. That's slightly less than Japan.

In addition, continued uncertainty along with a potential slowdown in growth in the U.K. and EU could cause the value of the dollar to rise further against most foreign currencies. A stronger dollar would make U.S. exports more expensive and imports cheaper.

Third, commodity prices, including the price of oil, are likely to fall as the pound slides, economic activity in the EU and U.K. slows, and the dollar strengthens.

A troubling aspect of these three scenarios is that the effects are concentrated in manufacturing and commodity producing sectors and geographic areas of the U.S. We have already seen the effects of the decline in oil prices in places like North Dakota and other energy-producing states. The fallout from Brexit could exacerbate these problems, though it is likely these three scenarios will play out gradually over time allowing these industries and areas some time to adapt.

For credit unions, over the longer term, slower economic growth could dampen deposit and membership growth, reduce loan demand and lead to increased credit risk. Credit unions in geographic areas with strong ties to the oil and gas and manufacturing sectors could be more at risk in the near term, because activity has already weakened significantly in those areas.

In the near term, heightened uncertainty in financial markets may continue to boost demand for U.S. Treasuries, which could push long-term interest rates lower. For credit unions, lower long-term interest rates could further compress net interest margins, holding down growth of net income and net worth.

But heightened financial market uncertainty may make it less likely that short-term interest rates will rise in the near term. Many analysts have speculated that this increased uncertainty, along with the prospect of slower growth going forward, may make it less likely that the Federal Reserve will raise short-term interest rates this year. However, it's still too early to tell if that's the case.

In sum, from the U.S perspective, Brexit has dimmed the growth outlook in other countries over the next few years and raised financial market uncertainty. That may eventually translate into somewhat slower growth in the U.S., with much of the effects showing up in the manufacturing and commodities sectors, as well as related or dependent sectors. In the near term, this uncertainty may hold down long-term U.S. Treasury rates, tending to keep the yield curve relatively flat for at least the next few months.

More importantly, the Brexit vote reminds us that economic and policy circumstances can change quickly and unexpectedly. Credit unions need to be aware of and ready to adapt to potential changes that could affect the short-term and long-term financial health of their membership. Also, with more financial market uncertainty likely, it becomes even more imperative that credit unions test the resiliency of their balance sheets and income statements against a variety of economic and interest rate scenarios.

You can find more information on the economic outlook, including an analysis of household spending and labor market trends, and the implications for membership growth in our latest Economic Update video, now available on NCUA's YouTube channel at http://bit.ly/1rU7foW (opens new window).